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Companies with low gearing levels have plenty to offer

SECONDARY capital-raising activity has continued to chug along this calendar year with an average of $2.88 billion raised each month, including $5.1 billion in October. Despite this, larger and smaller companies have begun to diverge in terms of their attitude towards debt. Average gearing levels for Australia's listed corporates began to rise again in the most recent financial year after two years of concerted effort to strengthen balance sheets.

SECONDARY capital-raising activity has continued to chug along this calendar year with an average of $2.88 billion raised each month, including $5.1 billion in October. Despite this, larger and smaller companies have begun to diverge in terms of their attitude towards debt. Average gearing levels for Australia's listed corporates began to rise again in the most recent financial year after two years of concerted effort to strengthen balance sheets.

The average ASX-listed entity's total debt/equity ratio declined to 47 per cent in FY11, from 75 per cent in FY09, then edged up to 48 per cent in FY12. But the average figures hide the movements of larger companies, which have swung back towards debt in a far more significant manner. On a market-cap-weighted basis, average debt/equity was slashed to 44 per cent, from 72 per cent, after the financial crisis, but in FY12 it shot up to 54 per cent.

Nineteen of the top 25 stocks increased their total debt/equity ratio, while among companies with market capitalisations between $50 million and $1 billion, only 29 per cent increased this gearing measure.

Of course, while we'd like to think this reflects the robustness of all these small companies, it also likely reflects, in part, the restricted availability of credit.

A similar trend is evident when we look at debt serviceability. The interest cover ratio (EBITDA over interest expense) has improved for both the average and median ASX-listed company. Yet when we weight by market capitalisation, there is a notable decline in FY12. Of the top 25 companies, 44 per cent lowered their interest cover in FY12, compared with only 16 per cent with sub-$1 billion market caps. Not that it has any alarm bells ringing - market cap-weighted average interest cover has declined to a still robust 30 times, from 41 times.

Looking beyond data for listed companies, data from the Reserve Bank and Australian Bureau of Statistics shows a 9 per cent increase in loans and other liabilities held by private non-financial corporations in FY12. Bank loans rose by 9.5 per cent.

Reducing things to the most basic of forms, return on equity can be improved one of three ways (as set out in DuPont analysis): increasing turnover increasing margins or increasing financial leverage. In this low-growth environment, financial leverage is the only obvious lever large companies can pull.

Running through the FY12 figures, three of the six companies with the largest changes in percentage gearing were infrastructure owners (and five of the top 20) who had hard assets to borrow against. Only two of the top 20 had increased leverage as a result of funding substantial M&A (telecommunications challengers iiNet and M2 Telecommunications).

While talk of lazy balance sheets may have recommenced (cynically we might note that banks are seeking to grow their business loan books to cover for mediocre growth in consumer debt), we continue to favour companies with lower debt levels. Low gearing not only means a more secure position for equity holders but significant option value for the company: it provides the option of pursuing an accretive acquisition the option to increase dividend payments to shareholders and the option to increase gearing at a later date, potentially an important point for larger suitors seeking to buy growth.

Of the 28 industrial and financial stocks we have under coverage, 10 held net cash positions at June 30. Among these 10 are some of the best performed ASX listings in the post-GFC environment:

Jumbo Interactive (JIN - $16.4 million net cash at June 30). Has returned 330 per cent over the past three years.

Lycopodium (LYL - $24.6 million, 124 per cent).

Webjet (WEB - $33.8 million, 122 per cent).

LaserBond (LBL - $1.4 million, 59 per cent.

Academies Australasia (AKG - $200,000, 50 per cent).

ClearView Wealth (CVW - $50 million, 26 per cent over the past year).

These returns are just the share-price appreciation - all of these companies have paid respectable dividends as well. For the most part, these companies have grown organically and in a methodical, progressive manner. They had sound business models that to varying degrees have proved scalable. They have not needed to gear up for acquisitions to satisfy market expectations for growth.

IMPORTANT: This information has been prepared without taking into account your objectives, financial situation or needs and you should consider if the information is appropriate for you before making an investment decision. Unless otherwise specifically stated or disclosed (such as the InvestSMART Diversified Portfolios Product Disclosure Statement), neither InvestSMART Financial Services Pty Ltd nor any of its Related Companies make any recommendations as to the merits of any investment opportunity referred to in its emails or its related websites. Product disclosure statements for financial products offered through InvestSMART can be downloaded from this website or obtained by contacting 1300 880 160. You should consider the product disclosure statement before making a decision about the product. All indications of performance returns are historical and can not be relied upon as an indicator for future performance.